On Branch Hill's MBIA Report

Important: Based on feedback from readers, the author has amended his original article. Below, the original article, followed by the author's reevaluation.

Shares of MBIA (NYSE:MBI) surged over 15% on Thursday, October 14, closing at $13, apparently due to a Business Insider article entitled “Why The Bond Insurers May Be The Huge Winners From The Brewing Mortgage-Bond Scandal.” The article, which can be found here, briefly highlights a presentation by Manal Mehta of Branch Hill Capital. The report was issued in June of 2010, but was not widely read until the Business Insider article, which provides a link to the presentation. The Branch Hill report argues, among other things, that MBIA will benefit if banks are required to repurchase a high percentage of bad loans they underwrote that were later securitized.

In many respects, the MBIA report is excellent. It provides many illuminating statistics, and is presented extraordinarily well. Unfortunately, when it comes to supporting its key thesis, that MBIA is a good investment, the report is very weak. MBIA is more akin to a legal lottery ticket than an investment, and a lottery ticket where the winning payoff is much lower than others with similar odds of winning. This article will discusses the report’s important analysis and conclusions in the order presented.

SLIDE 3

Slide 3 focuses on the adjusted book value (ABV) of National Public Finance Guarantee Corporation (“National”) as a valuation metric. Adjusted book value is a useful benchmark, but other factors need to be considered when using adjusted book value as a valuation metric. These include the following.

Future revenues: MBIA’s two main financial guaranty subsidiaries, MBIA Insurance Corporation (the “bad bank” that was stripped of $5 billion in early 2009) and National (the “good bank” that was funded with the $5 billion) have effectively been in run-off (they have not written new policies) for almost three years. Given the uncertainty and litigation surrounding MBIA’s restructuring, there is little hope that National will generate significant revenues for the foreseeable future.

Potential obligations: As of June 30, National was exposed to credit losses on $485 billion worth of bonds, or $2,421 per share. Any sane person would much rather have $21.43 (National’s adjusted book value as of June 30) in cash rather than $21.43 in tangible net assets plus the obligation to cover losses on $2,421 worth of bonds, including $13.90 that are junk rated and $222.81 that are rated BBB.

Operating expenses: Page 19 of MBIA’s second quarter operating supplement shows $0.10 billion of operating expenses for National for the first six months of this year, an annualized rate of $200 million. This rate should taper off as the portfolio amortizes over the next 20+ years, but shareholders should reasonably expect future operating expenses in the rough ball park of $1 billion ($4.99 per share).

These factors suggest that a price target above National’s ABV is wildly optimistic if the structured finance business is worthless. Here is the math:

Future revenues: $0, but could be negative if National underprices coverage in an attempt to show that the franchise is not dead.

Potential obligations: It seems fair to say that the average person would rather take $10.72 (50 cents on the dollar) rather than $21.43 that is exposed to credit losses on municipal bonds worth $2,421, including $13.90 of junk bonds, especially given that this money can only be released as the bonds amortize over the next 20+ years.

Company loss estimates: Assume that National’s loss estimates are perfect.

By this math, National is only worth $10.72 - $3.49, or $7.23. If MBIA attempted to sell National, it is debatable whether it would fetch for more than $1 billion ($5 per share). Unfortunately, if the structured finance business is worthless, as is widely believed, cash flows from National will also need to fund holding company debt worth around $3 per share.

Branch Hill acknowledges holding company debt, but ignores the obligation to fund any shortfall in MBIA’s wind-down businesses. MBIA’s second quarter operating supplement shows an adjusted book value of negative $3.98 per share for the asset management business.

Therefore, if the structured finance business is worthless, shareholders would not be entitled to $7.23 per share, the full unencumbered value of National. The holding company would first need to pay:

1.Debt worth about $3; plus

2.The shortfall in the wind-down businesses, estimated by MBIA to be $3.98 per share.

Including a modest amount of cash, this leaves holding company assets that are worth only slightly more than liabilities. The net result is a fair valuation for MBIA around $2 or $3 per share, assuming the structured finance business is worthless, not anywhere near Branch Hill’s $20.71+ price target.

SLIDE 6

Slide 6 quotes MBIA’s CEO Jay Brown claiming that MBIA's 2009 restructuring would “aid the federal stimulus efforts by providing access to the credit markets to fund shovel-ready infrastructure development, and it will help taxpayers by lowering the cost of that borrowing.” National has not written a meaningful amount (if any) of municipal bond insurance since the time of the restructuring, and bond buyers ascribe little value to existing guarantees. MBIA’s restructuring has failed spectacularly when it comes to the objectives quoted by Jay Brown.

This is unfortunate, because the bond insurance market has been reduced to only one company, Assured Guaranty. Having another viable market participant would improve the credibility of the business model.

If the New York Insurance Department really wants to help investors in insured municipal bonds and revitalize the municipal bond insurance business, it should require MBIA to sell National, because MBIA’s legacy is a cancer to the municipal bond insurance business. It might require some creativity, and it may require negotiating with MBIA’s structured finance counterparties, but one would think that the New York Insurance Department could require National to be spun off from MBIA, or create a situation where a spin-off would be in the best interests of management and shareholders. Selling National to outside investors would give the municipal bond insurance business a fighting chance of recovering.

SLIDE 20

This slide describes the loss projections from Pershing Square’s Open Source Model as a “Bearish Market Estimate.” In reality, these projections now look optimistic, not bearish. For example, Pershing Square’s $5.76 billion loss estimate for closed end second liens and HELOCs has now been eclipsed by MBIA’s RMBS loss estimates which include $4.6 billion of payments to date and $1.4 billion of future payments, or $6 billion in total.

A plausibly bearish loss scenario might involve future loss payments over $20 billion, including over $8 billion for second liens and multi-sector CDOs, $7 billion for commercial real estate, $5 billion on municipal bonds, and $2 billion for the remainder of MBIA's portfolio. This is over twice Branch Hill's bearish number.

If one believes that banks will need to repurchase hundreds of billions worth of bad loans, as Branch Hill does, then Pershing Square's CDO loss estimates could plausibly be too high. However, other investments will produce far better returns than MBIA shares if this happens (discussed below).

SLIDE 23-33

Slides 23-33 present Branch Hill’s key thesis: if MBIA is able to force banks to make large scale repurchases of bad loans, the shares become a great value. If this happens, the shares are a decent value, but far from the home run that Branch Hill suggests.

Branch Hill repeatedly uses adjusted book value as a proxy for shareholder value. To get a better idea about shareholder value, let us start with MBIA’s adjusted book value of $35.76 as of the end of the second quarter, and apply the same calculus that was applied to National’s ABV.

Future revenues: $0. In a scenario where MBIA recovers billions from banks, future litigation will be intense, and the associated uncertainty will make it virtually impossible for MBIA to underwrite any meaningful amount of new business.

Potential obligations: As before, a 50% haircut seems reasonable. $35.76 encumbered by the contingent obligation to pay any losses over the next 30+ years on over $3,000 of bonds (some very toxic) is worth no more than $17.88.

Company loss estimates: Branch Hill’s estimate of $4.5 billion is $2.5 billion more than MBIA is currently booking. Assuming MBIA’s loss reserves are otherwise accurate, these additional recoveries add around $12.50 per share on a pre-tax basis, or $8.75 after tax assuming a 30% tax rate. This increases the $17.88 to $26.63.

Operating expenses: $4.99 in operating expenses was previously estimated for National. The remainder of MBIA incurred $0.33 billion of operating expenses for the first half of 2010. Overall, shareholders should expect operating expenses to erode shareholder value by at least $10.48 ($14.97 net of 30% taxes). This brings us to $16.15

Wind-down operations: Let us be optimistic and make the math easy by assuming that asset values increase by enough to erase the negative $3.98 of adjusted book value, and add another $1.52. Assuming a 30% tax rate, this would add $3.85, increasing total shareholder value to an even $20. This is a 64.6% premium over yesterday’s closing price. If MBIA’s booked estimate of $2 billion for repurchase recoveries turns out to be accurate (instead of Branch Hill’s $4.5 billion estimate), shareholder value is reduced to $11.25.

Based on the calculations outlined above, the results of the “Outcome Tree” on slide 33 of Branch Hill’s presentation can be recreated with more realistic valuations. The results are tabulated below.

Article 78 Outcome

Value of Structured Finance Business

Loan Repurchase Recoveries

Shareholder Value

MBIA wins

Positive

$4.5 billion

$20.00

MBIA wins

Positive

$2.0 billion

$11.75

MBIA wins

Zero

NA

$2.50

MBIA loses

Positive

$4.5 billion

$20.00

MBIA loses

Positive

$2.0 billion

$11.25

MBIA loses

Zero

NA

$0.00-$2.50

Click to enlarge

The only outcomes that produce shareholder value greater than the current share price are ones where bank loan repurchases become very large

Branch Hill estimates repurchases will result in $250 billion in losses for large banks, including approximately $70 billion for Bank of America. This would be a nightmare scenario for Bank of America (NYSE:BAC). The losses, the administrative burden of dealing with repurchase demands, and a barrage of accompanying lawsuits would grind the bank's productive businesses to a halt at the same time that stakeholders lose faith. Bank of America would almost definitely need a bailout. Given the backlash over the previous bank friendly bailout terms, shareholders would do well if the shares held above $2 in 2011.

In this case, investors would do much better to purchase puts on Bank of America (and possibly other large banks) than they would with MBIA shares. For example, as of Friday, Bank of America 2012 $5 puts could be purchased for less than 30 cents. If Bank of America’s shares were to fall below $2 by the end of next year (as they probably will if Branch Hill’s estimates materialize), these puts would return ten times the original investment.

If banks need to absorb the high percentage (50%-60%) of loan losses that Branch Hill estimates, then there are many subprime and Alt-A RMBS tranches originally rated AA and A from 2006-2007 that currently trade at 5-10 cents on the dollar that will return 100% of principal plus interest. There are even some tranches that have already been wiped out by losses that could be purchased for around 2 cents on the dollar that should eventually recoup their losses and return 100% of principal plus interest.

Many analysts are skeptical that loan repurchases will be as large as Branch Hill believes. JP Morgan analysts Ed Reardon and John Sim argue that estimates like Branch Hill’s are “vastly overestimated.” Calculated Risk, a highly regarded blog that focuses on housing and the economy, expresses a similar view.

These analysts may be skeptical because most of the well-publicized arguments in favor of sweeping loan repurchases are weak on the surface. Two examples follow.

1.A brief quote from MBIA’s August 24, 2009 amended complaint against Countrywide (here.pdf) might be considered representative of MBIA’s legal arguments in general. Page 32 of the complaint states that telephonic employment verification “is obtained from an independent source (typically the borrower’s employer) [and] which verification reports, among other things the length of employment with that organization and the borrower’s current salary” (emphasis added in MBIA’s complaint). Unfortunately, the quote is from a prospectus section that describes Countrywide’s normal underwriting standards. Separate sections describe the standards for the types of loans included in the transactions insured by MBIA. For the Reduced Documentation Program, “documentation concerning income and employment verification is waived.” The Super-Streamlined Program requires telephonic verification of employment, but “no debt ratio, income documentation or asset verification is generally required.” It is not surprising that, after paying hundreds of millions of dollars in losses, MBIA would prefer standards that required things like salary verification, but unfortunately, this is not what MBIA guaranteed.

2.Federal Home Loan Banks are asking underwriters to repurchase a high percentage of defaulted loans from subprime and Alt-A transactions. The lawsuit is supported by a study showing that appraisals for a few thousand loans were almost 20% higher, on average, than a computer's valuations. On its face, this seems like a very weak argument. Flaws in the computerized model could be responsible for the difference. Even if the model were perfect, it is entirely likely that appraisers, like many homeowners and investors, were simply too optimistic about housing prices during the bubble. In the middle of 2009, appraisals were often much lower offer prices. This does not mean that appraisers were doing anything sinister. They were simply influenced by general pessimism about housing in much the same way that that general optimism influenced their appraisals during the boom years.

CONCLUSION

At anywhere near the current price, MBIA is likely to produce large losses for investors unless massive loan repurchases by banks provide a large boost to MBIA’s capital position (in which case, MBIA is a terrible investment when compared with other alternatives). If repurchases are not so massive, shorting MBIA is a good stand alone bet and a great hedge, because any of the following could trigger an 80%+ slide in the share price:

Addendum: A comment made by a reader highlights an erroneous reference to information in MBIA's second quarter operating supplement. The reference is made in the discussion of slide 3: 'Page 19 of MBIA’s second quarter operating supplement shows $0.10 billion of operating expenses for National for the first six months of this year'. The numbers shown on page 19 of the operating supplement are per share, not in billions.

The intent was to quantify the future expenses of managing National's portfolio as it runs off. The estimate provided in the article is reasonable, but it is not consistent with the operating expenses on page 19, which exclude loss adjustment expenses.

A reasonable estimate for these expenses can be made based on National's 2009 Annual Statement. Line 25 of Part 3 of the Underwriting and Investment Exhibit (page 11) shows total incurred expenses. The sum of net adjusting and underwriting expenses less commissions (commissions are shown in line 2.8 and are non-recurring) is $146 million. If the $146 decreases going forward in proportion to the net par amortization schedule on page 32 of the second quarter operating supplement, the result is $1.2 billion of present value adjusting and underwriting expenses, $200 million higher than the $1 billion estimate provided in the article. This difference is roughly equal to the $1.04 per share loss provision embedded in National's unearned premium reserve, which should also be added to the valuation of National based on adjusted book value. The net impact of these revisions is neglgiible.

An implicit assumption in the above calculations is that National's loss reserves and the $1.04 loss provision embedded in the unearned premium reserve (included in the calculation of adjusted book value) are adequate to cover actual claim payments, but not loss adjustment expenses. Whether or not the reserves should in theory include a provision for loss adjustment expenses, it is clear that they are not remotely close to adequate. The total provision of around $2 per share (loss reserves plus the loss provision embedded in the unearned premium reserve) is barely enough to cover 3 years of loss adjustment expenses and no losses on a $485 billion portfolio that will run off over the next 20+ years.